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July 15, 2013

How Business Cycles and Stock Prices Interact

The chain of events goes something like this: economic expansion, more lending, more sales, higher profits and stock prices

During the phases of the business cycle, inflation, housing starts, consumer credit, auto sales, etc., have a tendency to follow a general historical trend. Assuming there is some relationship between economic activity and stock prices, in this post we'll examine a few of these tell-tale signs and discuss how they may lend insight into the future stock price movement. Of course, a brief post is clearly insufficient to cover such a vast topic such as this, but it may prove beneficial to focus on a couple of keys in the process. Let's begin by defining the business cycles and discuss how certain economic measures tend to trend during the different stages of the cycle.

The business cycle has four phases:

Expansion

Peak

Contraction

Trough

Most recently, the cycle hit bottom (trough) in the U.S. in mid 2009 and has been slowly expanding since then. However, this expansion is historically weak as compared to the majority of past expansions. During this recovery, GDP has struggled to surpass 2.0%. GDP is officially published three times after each calendar quarter. The second time (i.e.; first revision) for Q1 2013 was 2.4%. However, in late June it was revised downward to its final figure of 1.8%.

When the economy is expanding, it's common to find housing starts trending higher, along with consumer credit and auto sales. In short, an increase in economic activity begets economic expansion which begets more lending which begets more sales which results in increased corporate profits, which are critical to higher stock prices. Also, during periods of expansion, demand and sentiment rises and inflation often declines, at least initially. Recently, consumer sentiment fell slightly which coincides with the downward revision in Q1 GDP.

The difficultly in forecasting the future of stock prices lies partly in knowing what stock investors will buy based on what they believe is going to happen, which is essentially an educated guess. For instance, if investors believe economic growth is about to rise sharply, they would buy heavily and stocks would rise accordingly. Then, when reality arrives, if they've guessed correctly, absent any other catalysts, stock price movement may be somewhat subdued as the positive news would've already been priced in. However, if their guess were wrong and the economy contracted, and especially if the contraction were severe, stocks would fall hard. Part of the reason for this is that stocks would've risen sharply based on the good news and, hence, would have even farther to fall.

Even though this recovery has been one of the weakest since the Great Depression, stocks which fell dramatically (after rising dramatically during the housing bubble), have been rising as if the economy were booming. However, without the Fed's intervention, I doubt we would've seen anything close to the rise we've had.

Where do we go from here? If the divergence between expectation and reality is great, the market adjustments would tend to be more extreme. However, as long as the Fed remains accommodative, and Europe doesn't implode, and China's GDP doesn't contract too much (it just announced GDP of 7.5%, matching estimates), and the upcoming U.S. earnings season doesn't disappoint, I believe domestic stocks could continue to trend higher. There are many other catalysts, but these are a few of my favorite things.

Next week, we'll expand this subject and discuss in greater detail how certain economic statistics typically react during the various phases of the business cycle. In short, I suppose you could say that the business cycle—and the market, for that matter—doesn't always follow the rules. This is because bubbles come in various sizes and their incubation period fluctuates. Therefore, because the extremes are often just that, extreme, we need to remain somewhat cautious. However, one cannot afford to stay away from stocks completely as it seems they remain the only game in town, thanks in great part to Big Ben! Oh, I forgot to mention that his impending retirement and chosen successor could also have an influence on the markets.